‘It’s fine to celebrate success but it is more important to heed the lessons of failure’
We all are aware of this famous quote by Bill Gates but do we actually mean by it? or for the time being let us stick to Silicon Valley Bank (SVB) or more specifically US, did US follow this thing?
Interestingly, the answer is “Yes, they followed it”. Now, the question arises, if US government was moving in the right direction, then what is leading US towards the failure of banks one by one? Is it only inflation to which we can easily blame? Is it the recent pandemic which is still available to put a blame?
The global leader, US can present whatsoever picture it wanted to show to this world but the truth needs to be dig out.
Let’s begin….
The Wounds of 2008
You all might remember the Global Financial Crisis (GFC) or the Great Recession of 2008. The biggest recession witnessed by most of us. I still remember how newspapers were filled with lay-off news, shutdowns of big corporates, failing of banking systems and what not. The whole world suffered from those crisis and US was solely responsible for that.
According to a 2011 report by the Financial Crisis Inquiry Commission, the Great Recession was avoidable but on the same side, we should also remember that it’s not only about the US or any another specific nation, but these kinds of failures become the foundation stone of regulations which were non-existent earlier, and it is obvious to remember that all problems are not predictable.
But for understanding the current failure, it is very important to drive through the past and see what had been mentioned by the Inquiry Commission in its report.
As per the inquiry commission, the following reasons were responsible for the failure in 2008:
- The most common reason was failure of the Government to regulate the finance industry.
- The increased shadow banking system in US – this is the system in which some companies start lending money to customers without obtaining the status of a bank. So, from the 2008 US perspective, we can describe shadow banking as a loop in the banking system which need not to be governed by specific set of regulations as the banks were and hence, this went unregulated which started operating in the nation equivalently to banks.
- The excessive borrowing by consumers and corporations. This created asset bubbles due to which prices went very high, especially in the housing market as mortgages were extended at low interest rates to unqualified borrowers who subsequently could not repay them.
It was the US federal policy in 2004 under which it was encouraged to own a home by every family and that’s how low interest rates by banks and shadow banks were helping in fulfilling this dream. That was the same time when new type of financial products were also introduced in the market, the popular amongst them was Adjustable-Rate Mortgages (ARM). This is one of the most famous financial product in various nations of the world under which interest rate fluctuate periodically based on the performance of a specific benchmark. This is different from fixed interest loan as in ARM the initial interest rate is fixed for a period. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals. This means that a customer benefit from falling rates and run the risk if rates increase. So, this kind of financial product allowed those customers who were resistant earlier and now they developed the expectation that interest rates would remain low and home prices would continue to rise.
This seems to be a happy ending story so far where everyone got the loan on low interest rate under their paying capacity but then the other issues started in the country. We should not forget that banking system is just a part of the economic system and not the complete economy and that’s how it got its first shock.
The US federal increased the interest rates for controlling the inflation at that time. As interest rates rose, the flow of new credit through traditional banking channels into real estate slowed and on the same side, existing borrowers went out from their paying capacity and banks were hit hard.
It is estimated that 20% of mortgages in 2005 and 2006 went to people who would not have been able to qualify under normal lending requirements. 75% of these people were borrowers who borrowed money under ARM with low initial rates and a scheduled reset after two to three years.
This led to the beginning of credit crisis and eventually various investments banks started collapsing including the bankruptcy of 4th largest investment bank of US, Lehman Brothers.
Dodd-Frank Wall Street Reform and Consumer Protection Act or Dodd-Frank Act, 2010
Now, coming back to my quote, Did US learn lesson from this? As I mentioned in the beginning, Yes, they learnt the lesson in 2008 and since then various policies were brought in the upcoming years which includes Quantitative Easing (QE), American Recovery and Reinvestment Act etc. but in 2010, US Congress under the leadership of President Barack Obama passed the Dodd-Frank Act, which gave the government expanded power to regulate the financial sector including greater control over financial institutions. It also created consumer protections against predatory lending (imposing unfair, deceptive, or abusive loan terms).
The Dodd-Frank Act is an extraordinarily complicated regulation that covers a wide coverage of financial industry activities. Under this act, several new government agencies tasked with overseeing the various components of the law and, by extension, various aspects of the financial system.
2018 – Beginning of a new Failure
Till now, things are very clear that how 2008 financial crises happened and how the crisis led the formation of this new act which gave various regulatory powers to the government but thigs changed again in 2018.
It was none other than a political move when US government in 2018 changed the applicability provisions of Dodd-Frank.
President Donald Trump described this act as a disaster and rolled back various provisions of this act. As per the amendments by Trump, now various small and regional banks were exempted from this regulation and the amended law also weakened rules which were intended to protect big banks from collapse.
Ultimately, it reduced the number of banks to be covered under this regulation and reduced the applicability of annual stress test to a very limited number of banks.
Annual Stress Test: One of the provisions of Dodd-Frank Act was annual stress test under which all the regulated banks and financial institutions were required to pass a stress test which helps to determine that whether a bank is prepared to face any upcoming recession shocks. The test is based on the hypothetical scenarios to access the impact different financial shocks might have on their stability.
Some of the media reports mentioned that Trump government took political contributions for campaigns from lot of small banks to whom he paid back by de-regularising the provisions of Dodd-Frank Act.
Why SVB?
Historically, SVB was very booming bank and it was in the list of one of the largest banks of US.
During pandemic, when the economies of various nations were collapsing, lot of venture capitalists who were investing in various start ups reduced the interest rates to 3% or 2% and some had reduced to 0 as well. Instead of interest, they were dealing in equity.
In the US, situation was same. The start ups were funded heavily by these investors instead of banks.
As banks were not getting customers for business loans due to higher rate as compared to venture capitalists, banks started investing their deposits to earn money.
Asper the media reports, SVB is one of those banks which has made good relations with the Silicon Valley companies due to which lot of deposit from those companies, start ups, investors started coming to SVB.
SVB Financials:
The bank had around 190 billion dollars in assets out of which 85% of its deposit comes from 38,000 corporate accounts only which means on an average 4.2 million dollar per account which included VC funds and tech and life-science companies, and most of its loans went to those companies too.
As mentioned above above investing of deposits, SVB invested its deposits in various mortgage back bonds, government bonds etc. The investments were typically long term.
But here comes an issue: Inflation hit the market and as done in the past, the interest rates were increased to control the inflation which is a normal practice to control the inflation in short run.
The money which was easily available to start ups via venture capitalists earlier is now started vanishing. By this time, the start ups which were funded by the investors started expanding and they need more money. The increased need of money by start-ups pushed the investors to withdraw their deposits from SVB which created the panicking situation for the bank as then the bank realised that they don’t have this much liquidity to pay so many people together.
Here comes the downturn:
The interest rates of the bonds in which SVB has invested increased as the investments were long term and the bank was attempting to sell them too early due to which investments started making loss. There is an inverse relationship between price of a bond and interest rate.
The bank made a loss of 1.8 billion dollars on selling of these investments. The depositors on the other hand, started taking their money back. Now, here comes the situation when the deposits were decreasing rapidly and to pay more deposits, bank is selling its investments and making loss.
Role of FDIC:
The Federal Deposit Insurance Corp. (FDIC) is an independent federal agency insuring deposits in U.S. banks and pay back the money to the account holders on the behalf of banks in the event of failure.
But, that doesn’t mean that each and every penny will be paid. The FDIC insures deposits up to $250,000 per depositor till the failure of SVB. Now the limits are being revised.
In SVB, most account holders have more money than this limit of 2.5 lac dollars per depositor which means the depositors had no other option than to withdrawal as their money would not be protected if SVB fails.
Fear being the biggest enemy led to the failure of Signature bank as well as the depositors started taking out their deposits rapidly.
As the media reports started coming out, Is Credit Suisse going to be the next one?
Conclusion: Who is responsible?
Inflation being the most common evil seems to be the biggest reason for SVB failure but inflation is a continuous thing which can’t be ignored while accessing any future projections. In my belief, the biggest reason behind the failure is lack of regulation by the government on the banking system of US.
I am again coming to the quote by Bill Gates and asking this question, “Did US learn lesson from the 2008 crisis?” The answer is, “No, they compromised”.
